Yogi Berra, the iconic American baseball catcher, said: “Make a game plan and stick to it. Unless it doesn’t work out.”
US Federal Reserve Chairman Jerome Powell may have had this quote in mind when he delivered his “Jackson Hole” speech on August 26, as the world’s central bankers gathered in Wyoming for their first in-person economic symposium in a few years.
Unlike his more optimistic and discursive effort for 2021 (promoting maximum employment and transitional inflation), Speaker Powell was short and to the point, taking just 8 minutes and 49 seconds to deliver his speech. The imperative of price stability and the burden of high inflation falling on those least equipped to deal with it were at the forefront.
The president promised to forcefully use the tools of the Federal Reserve to rebalance supply and demand, with the aim of bringing inflation back to the Fed’s 2% target. The consequences were spelled out in clear terms; the medicine would be unpleasant, it might be needed for a while, and households and businesses would feel the pain.
This austere and unusually pointed language from a central banker more accustomed to providing the markets with subtle cues by light pressure on the bar, clearly indicates how difficult it will be to untangle the inflationary Gordian knot.
To quote President Powell’s own words:
If the public expects inflation to remain low and stable over time, then, absent major shocks, that is likely to be the case. Unfortunately, the same goes for high and volatile inflation expectations. During the 1970s, as inflation rose, the expectation of high inflation became entrenched in the economic decision-making of households and businesses. The higher inflation rose, the more people expected it to stay high, and they incorporated this belief into wage and price decisions. As former President Paul Volcker said at the height of the Great Inflation in 1979, “Inflation partly feeds on itself, so part of the job of returning to a more stable and productive economy must be to break the grip of inflationary expectations.”
What does all this mean for private capital?
The US dollar and US Treasury bills remain two of the world’s most important financial instruments, setting the tone and benchmark for global interest rates. The ripple effects of any substantial change in American policy are felt everywhere. And the Federal Reserve remains the “daddy” of all central banks.
In an environment of high inflation, central bankers have two essential policy tools to achieve the objective of low and stable prices. The first concerns interest rates and the second, quantitative tightening.
Both lead to higher borrowing costs for businesses and individuals, leaving less disposable income to drive discretionary purchases in supply-constrained developed economies with high employment rates.
The effect that central banks are hoping for is a moderation in price increases and wage demands as the economy “cools down”, always hoping that they can do so without triggering a substantial recession.
The force of the language used by President Powell implies that the critical objective is to stifle inflation before it becomes unsolvable and higher unemployment and a recession could be the price to pay. Headwinds are forming.
Public markets reacted decisively, with US Treasury yields and the dollar rising in anticipation of further rate hikes and all three US equity indices falling more than 3%.
The most likely effect of this level of uncertainty is to slow M&A activity, at least for a while, as price swings in public markets begin to trickle down to private companies. The nettle of falling revenue projections and rising labor costs will have to be grasped at some point, with buyers seeking to reassess target prices and owner-managed businesses understandably reluctant to abandon the heady valuations of these last years.
A period of adjustment will be necessary with each new economic data rigorously examined. The September 20-21 FOMC meeting will carefully assess the nonfarm payrolls numbers due September 2, and we’ll likely see another 0.75bp rate hike with 0.25/50bp increases after the November 12 and December 13.
The recent Debevoise & Plimpton 2022 Private Equity Mid-Year Review and Outlook provides insight into how private markets are handling these economic turbulences. The report chronicles the drag effect of lingering geopolitical and economic uncertainties with an even more competitive fundraising climate for the second half of the year. The use of storage vehicles, the active participation of funds of funds and continuation funds should all be included.
Continuation funds are a valuable way to address market timing issues, providing the ability to protect high-performing trophy assets from premature sell-off. Initially tainted by the stigma of assets spending time in the recovery service, they have evolved into a valuable portfolio management tool allowing businesses to grow to their full potential. Liquidity can be created for the sponsor if desired, but in times of volatility many prefer the ability to stay invested in a familiar, well-performing asset.
And, of course, for those with committed but unused capital, the opportunity for contrarian investments in targets with more attractive valuations and inflation-fighting characteristics will support selective trading activity. Investments in energy transition, food security, infrastructure and the re-mapping of supply chains will be the subject of significant new commitments. And while banks may be more demanding on terms and covenants, this will open up new space for private credit to occupy.
As Yogi Berra also said, “It’s hard to make predictions, especially about the future”
There is no doubt that headwinds are building and choppy waters lie ahead. Still, the global private equity industry will adjust its sails and navigate successfully through the challenges ahead.
Next time: private capital and regulation
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